Parts of capital
Now that we have a good idea about capital in banks, let’s learn about various types of capital. These different types of capital differ based on who the provider is, what the capital feature is, and what the importance of that particular type of capital is when viewed from a regulatory perspective.
Capital is also broken up into three parts—Tier 1, Tier 2, and Tier 3. Tier 1 is considered the safest. Tier 2 is less safe. Tier 3 is the least safe.
Types of capital
Depending on the tiers, the most important types of capital are
- Common stock (or shareholders’ equity)
- Preferred stock (or preferred equity)
- Revaluation reserve
- General provision
- Hybrid instrument
Common stock is the most secure form of capital, as stock holders are fractional owners of a bank and accept all bank risks and liabilities.
Preferred stock is considered a contribution to capital. Preferred stock has a priority over common stock—dividends must be paid on preferred stock before common stock. Preferred stock generally carries no voting rights.
Revaluation reserve is a capital that is created when a bank asset is revalued at a price higher than its historical value. Assume that a bank sells a building that it had bought many years back at $10,000 for $60,000. The difference of $50,000 would be the revaluation reserve.
General provision is created when a bank sets aside some money on a loan it has given to provide for expected future loss. General provision is included as part of the capital provided so that no diminution in asset value has taken place.
Hybrid instrument refers to an instrument that has some features of both debt and equity. A hybrid instrument issued by a bank can be included as part of bank capital if it has a feature where any loss on the instrument’s face value is borne by the instrument holder and not the bank.
Now that we know the different types of capital in banking, we’ll look at why capital is essential to banking.